New Delhi: The Reserve Bank of India (RBI) and the government now appear to be on the same page as they express concerns about inflation, which has been mainly driven by rising food prices.
Monetary policy tightening is widely expected by the end of January, even as government officials and the central bank chief note that the supply-side constraints that have made food more expensive are generally outside the scope of monetary policy.
Such apparent harmony is not always the case.
In the weeks leading up to the last quarterly policy review in October, Reserve Bank of India governor Duvvuri Subbarao talked tough on inflation even as growth-focused government officials repeatedly urged the Reserve Bank to hold off on tightening until an economic recovery was more entrenched.
The RBI ended up starting the process of unwinding ultra-loose policy by removing emergency liquidity support measures and taking other steps, but stopped short of raising rates or lifting cash reserve ratio (CRR) requirements for banks.
Its next policy review is at the end of January, and economists widely expect the Reserve Bank of India (RBI) first to increase CRR and then raise rates in coming months as inflation is forecast by some to reach 8% by the end of the fiscal year in March and other indicators point to a strengthening economy.
Here are some questions and answers about the independence of the Reserve Bank of India.
How independent is the RBI on paper?
The RBI is not constitutionally independent, as the 1934 act governing its operation gives the government power to direct it. As tends to be the case globally, the government appoints the central bank governor. It also appoints four deputy governors.
“The central government may from time to time give such directions to the Bank as it may, after consultation with the governor of the bank, consider necessary in the public interest,” the act says.
Technically, the government is also permitted by the act to supersede the central bank if it believes the RBI has failed to carry out its obligations.
What happens in practice?
Over the last quarter century, the RBI has been seen to be more independent as India’s economy has liberalised, although much consultation takes place between the central bank and the finance ministry, and the government has been known to exert its will, against the wishes of the central bank chief.
“There is no legal act mandating autonomy of the RBI, but there is a growing convention that the RBI is allowed autonomy to do what it wants,” said Shankar Acharya, an economist with New Delhi-based think tank ICRIER and a former chief economic adviser to the government.
Earlier this month, as speculation swirled over possible monetary tightening, Union finance minister Pranab Mukherjee and RBI governor Subbarao met to discuss the economy.
Such consultations, which Acharya described as ”substantive,” are not unusual in India.
Is ‘consult’ just a polite word for ‘government order’?
Not necessarily. The RBI and government have clashed over monetary policy in the past, notably during the tenure of the previous RBI governor, Y V Reddy, and then-finance minister Palaniappan Chidambaram.
In 2007, global interest rates were softening but the RBI under Reddy preferred to adopt a hawkish monetary policy, citing inflationary risks stemming from higher oil prices. But the government favoured lower interest rates to help sustain high growth and bring relief to borrowers.
The RBI’s view prevailed and it hiked policy rates.
In June of the following year, however, Reddy was prodded by the finance ministry to raise rates against his wishes, he revealed in an interview after he left office.
So what governs the RBI’s independence?
Personalities. Reddy, for example, was “fiercely independent”, according to Surjit Bhalla, head of Oxus Investments in New Delhi.
Subbarao is seen as more open to consultations with the finance ministry, although he has demonstrated independence with criticism of the government’s fiscal deficit and early warnings on inflation.
What other influence can the government have?
Appointments. Chidambaram appointed Subbarao, who was the top bureaucrat in his ministry, as central bank governor, bypassing Reddy’s deputy Rakesh Mohan, who had been seen as a strong candidate.
The government can also issue directives on non-monetary policy matters such as foreign investment rules in the banks.
Who then should investors be watching?
Both the government and the RBI.
Top officials, including the finance minister, Prime Minister Manmohan Singh, and Planning Commission deputy chairman Montek Singh Ahluwalia speak frequently on matters of monetary policy, and their views influence policy decisions.
It is Subbarao, however, who decides the timing, means, and degree of policy moves.
“It’s kept grey,” said Acharya. “Fortunately, there is growing convention for autonomy. I don’t think the RBI is being dictated to.”